Todd P. Martin’s personal experience with deflation-inflation’s evil twin-was fairly typical for an American.
Martin recently went shopping for a computer. He decided on a Gateway model and sent an order to the South Dakota-based manufacturer. Two days after he opened the box, the machine dropped $150 in price.
Two weeks later, it dropped $250 more. Martin’s frustration was muted because Gateway had built a 30-day price protection guarantee into his purchase. The company expeditiously refunded him $400.
That’s deflation for most Americans today: Prices go down, consumers pay less-and they like it. “We don’t have true deflation yet,” says Martin, chief economist at People’s Bank of Connecticut in Bridgeport, which with $11.3 billion in assets is the state’s largest bank. “If we do see it, the deflation we’ve experienced is really the good kind.”
Deflation for much of the rest of the world is different story. Consumers in Japan are so terrified by falling prices that they’ve stopped buying and wages are stagnant-in some sectors even declining. In Indonesia, the 31-year-old dictatorship of President Suharto has been supplanted by food riots and looting of Chinese-minority owned businesses. In South Korea, an entire generation of workers is experiencing mass unemployment for the first time. In Russia, the currency deflates as fast as foreign governments and investors can pump money in to re-inflate it.
Yet their deflation is our deflation, as foreign markets for American goods wither and desperate overseas manufacturers dump their inventories on American docks at business closing prices. Asian deflation is showing up not only in bargains at local computer stores, but in layoffs at Boeing, Intel, National Semiconductor and MCI WorldCom and scores of other Fortune 1000s.
“There are lots of goods-producing firms that are having to wrestle with this,” says David McClain, professor of financial economics at the University of Hawaii. Pulp and paper manufacturers tell McClain of absorbing 25 percent reductions in shipments over the past year. Steel is so scared by Asian dumping it’s run to Congress for protection.
So far, the effects of global deflation on Americans have been limited to companies with markets in-or competition from-hard-hit Asian countries. The question lingering on some very important minds, then, is whether and under what circumstances deflation might get its passport stamped for an extended visit to the United States.
There! He said it!
The effect of Federal Reserve Chairman Alan Greenspan’s comments on a November 1997 audience was primarily incomprehension. Few on the House Banking Committee seemed to understand that his use of the “D” word crossed a lexical Rubicon.
In the financial press and markets, however, Greenspan’s invocation of deflation as a Fed concern was morally equivalent to Grandma swearing a blue streak over Christmas dinner. Suddenly, a subject that had been the purview of fringe theorists and Dow doomsayers was the topic of conversation among central bank chieftains and heads of state.
There are certainly facts to warrant concern today. From December 1997 to November 1998, the last 12-month period for which complete figures are available, the Producer Price Index fell 0.7 percent. For the 12 months preceding that, it was down 1.2 percent. Not a big decline, economists agree, but worrisome nonetheless, because it’s continuous.
“You can make a case that there has been a slight deflation at the producer level,” says Dave Huether, director of economic analysis at the National Association of Manufacturers in Washington, D.C. “That’s what the numbers tell you.”
The government breaks the PPI down into three major components: crude, intermediate and finished. Huether analogizes these to the process of turning wheat into flour and flour into bread. Finished goods prices dropped 0.7 percent from December 1997 to November 1998, compared with 1.2 percent in the previous 12 months. Intermediate prices dropped 2.9 percent for the former period, 0.8 percent for the latter. But crude prices fell 15.8 percent for the 12 months up to November 1998 and 11.3 percent the year before that.
That latter number was driven mainly by cheaper energy. Crude oil prices fell 40 percent in 1998, notes Dan Laufenberg, vice president and chief U.S. economist at American Express Financial Advisors Inc., in Minneapolis. The last comparable decline in crude prices occurred during the much-publicized crash of 1986, when oil lost 28 percent of its price.
While producer prices tanked, the consumer price component of the Bureau of Labor Statistics inflation index continues to register slightly positive numbers-the consumer price index (CPI) was up about 1.5 percent for 1998. Service price inflation, which accounts for 60 percent of the CPI against the goods component, was 2.5 percent for 1998. And wages rose about 3 percent.
Why the mixed signals? Producer prices are under pressure from devalued foreign currencies, bloated inventories and global excess capacity, all of which drive overseas competitors. Consumer prices, though, can remain stable or even rise somewhat in response to wage pressures because U.S. companies invested heavily in productivity-enhancing technologies and techniques during the last decade. “Our companies don’t compete through cheap labor,” Huether notes. “They compete through high productivity.”
“So far, this whole global financial crisis has been a net gain for consumers,” Martin says. Consumer prices are stable, wages are rising, the economy appears healthy. So why is Alan Greenspan worried about deflation?
Keeper of the flame
In P.Q. Wall’s opinion, Greenspan can’t be worried enough.
“The next 24 months will see a ’29-style crash,” predicts Wall, editor of The P.Q. Wall Forecast, a monthly investment newsletter published from New Orleans. An adherent to the controversial Kondratieff theory of 60-year-long boom/bust cycles, Wall says, “The only thing that’s going to be good to own between now and 2013 is bonds.”
Wall, who predicted both the 1981-82 prime interest rate peak and the start of the current bull market, believes Asia’s economic tidal wave is looming over American business. “We’re having a boom right now because we’re the only part of the city the flood hasn’t reached yet.”
Raymond J. Keating takes a different tack. “When you see the workings of the market going off track, it’s usually linked to governments doing something stupid,” says Keating, chief economist for the Small Business Survival Committee in Washington, D.C. “Usually something egregiously stupid.” One of the stupider moves government made in recent history was taking the dollar off the gold standard, he believes.
Whatever explanation one ascribes to the current economic dilemma, Wall, Keating and others agree the drama has one key player: Alan Greenspan.
“Our people are very confident,” says Richard L. Babson, chairman and president of Babson-United Investment Advisors, Inc., a Wellesley, Mass., registered investment advisory. Babson manages $2 billion in assets for institutional and high income investors. Countries and companies coping with deflation worries need discipline, infrastructure and institutional memory, Babson says, “and we have that in spades with Alan Greenspan.”
The Federal Reserve is America’s bulwark against both deflation and inflation, Babson and others says, because both are monetary phenomena. Classic deflation, properly defined, means a shrinking money supply, Babson notes, not just persistently falling prices, wages and interest rates. “Politically it’s more palatable to have inflation than deflation,” Babson says, though the Fed is disinclined to permit either.
“This deflationary impulse will be forestalled if the Fed clearly understands its role, which is to reflate the economy with sufficient liquidity,” says David McClain, the University of Hawaii professor, who also advises for Babson-United. “We shouldn’t underestimate the Fed’s enthusiasm for a low inflation rate. That’s where they live.”
But it’s
n
ot a safe neighborhood. Scott L. Greiper, director of research at Barington Capital Group, says low interest rates are the only thing that allow a nation with virtually no savings to continue spending. Wages appear to have risen alongside a very low rate of inflation. But adjusted for inflation, wages remained stagnant throughout the current seven-year American economic expansion. The Federal Reserve may be walking a tightrope between controlling money supply to stave off inflation or deflation and the need to keep interest rates down to fire a maturing expansion.
“I think we’re walking a fine line,” says Jan Holman, vice president for investment services at American Express Financial Advisors.
Coping with uncertainty
A deflation joke: The good news is, gasoline will soon cost just 35 cents a gallon again. The bad news is, at that price, you won’t be able to afford it.
Deflation talk took a siesta this fall, as the Asian crisis seemed to ebb and a trio of quarter-point cuts in the Fed’s prime interest rate eased consumers-the undisputed champions of America’s economic resurgence-through the Christmas holiday season. While there haven’t been any gruesome reminders of foreign crises, no bloody revolutions or collapsed financial houses, worry is creeping into some decision-makers’ outlooks.
“The economy is like a tuning fork; it’s very finely pitched,” says Charles Freeman, chairman and CEO at Commercial Capital Corp., one of New York City’s largest small business lenders. “You’re always trying to tweak it a bit.” Big companies that have squeezed every efficiency from their operations are under pressure from shareholders to keep earnings high and so turn to mergers or acquisition of promising smaller companies. Resulting layoffs too frequently fill the streets with unemployed nonconsumers.
“The question,” Freeman says, “is how quickly does the small business economy pick up these lost jobs?” It took seven years for New York to soak up the last round of mass layoffs spurred by merger-and-acquisition frenzy. “If any sector of the economy is able to pick up the slack of layoffs in the economy, it’s the small business sector.” But with initial public offerings reporting spectacularly poor returns, many small companies can only boost their earnings by becoming takeover targets.
“Deflation is a horrendous thing for all companies, but small caps are hit particularly hard,” Greiper says. Small business is concentrated more in the service sector, which is less exposed to the international crisis. They tend to have better earnings than larger companies with higher overhead, inflated shareholder expectations, and cost concerns. But investors expect more at a time when companies are frequently delivering less. Greiper says many investors are abandoning small caps for more secure stakes in older, bigger firms. Small cap stock performance was anemic in 1998, he and other analysts note.
For the moment, the crisis in general and deflation in particular seem to be at bay. “We’re doing quite well, and Europe is doing quite well,” says Babson of his top-hat clients. “The question is whether [the crisis] is going to spill over into South America.” Babson sees a one in three chance that Japan’s depression will deepen, or Brazil will suspend debt payments, or some other calamity will befall world markets, bringing recession on the United States.
Yet in Todd P. Martin’s bank, customers still line up for home mortgage refinancing loans, even as interest rates continue to fall each month. Customers don’t wait for lower rates; if the rate drops 50 or 100 more basis points, they simply refinance again. “Overall I think people still have an inflationary mindset, or a price stability mindset,” Martin notes.
It took the Federal Reserve most of a decade to wring out of the American psyche the ’70s-era expectation that grocery store prices would be higher every time they shopped. That mindset is generally agreed to have emerged after the 1973 oil price shock, when gas prices tripled in a year.
The jury is out on whether the Asia crisis will be recalled as a bookend turning point in mass economic psychology. For now, from his office at the bank, Martin says simply, “I’m starting to sense more of an awareness of what deflation is.”
